Newsletter

December 29, 2005

To Our Valued Clients and Friends:

I have a neighbor with whom I have enjoyed talking with over the past few years, and as the holiday season unfolded, we found ourselves meeting at several Liberty Park gatherings. During one of those meetings a discussion began about the tone of my last quarterly investment letter. I have been sending this fellow my quarterly letter even though he has not yet seen the wisdom of becoming a client of our firm. He has an attractive wife, with a good tennis game, and I wanted to stay on their good side. About half way through our conversation, my neighbor revealed that he shared my last letter with his employees. Because of the precautionary tone of the letter (remember the “perfect storm of debt”?) and the suggestion of falling real estate prices on the Gulf coast, the fellow told his staff that I was a curmudgeon.

As a Kentucky boy I knew immediately not to say thank you for this new label, but after digging into my Funk and Wagnall I questioned his saying that I am an, “ill tempered person full of resentment and stubborn notions.” I think he was just offended at my suggestion that his Gulf coast real estate balloon might have sprung a leak. He may, however, be right about my stubborn notions, because I find myself looking at the New Year with the same concerns about the current value of the market that I had at this time last year.

I apologize in advance for asking you to focus your attention on my most stubborn of notions, of which I have often spoken. This involves evaluating the value of the market by using the Fair Value Price Earnings Ratio (FVPER). While a discussion of FVPER may not be the most entertaining course for our year-end letter, I believe a review of it will confirm that this ratio was correct in predicting the performance of the market in 2005. It was also “dead on” in evaluating the market’s value in both 2000 and 2002.

Before I begin, here is a quick outline for the remainder of this letter:

1. I.    FVPER — And the lessons we can learn
2. II.  2006 — Some Thoughts
3. III. 2005 — Market Observations
4. IV. Odds and Ends

I. FVPER – the ratio – and the lesson we can learn – The Fair Value Price Earnings Ratio (FVPER) – A ratio that is determined by dividing the prime interest rate into one. The result suggests an approximate price earnings ratio that current market conditions may support. Remember, the price earnings ratio, which investors used to determine how much they are paying for a dollar’s worth of corporate earnings, is found by dividing the price of the stock by the corporate earnings per share. (i.e. A stock selling for $30 a share with earnings of $3 per share has a price earnings ratio of 10. Thus investors are paying $10 for a single dollar of earnings). Because different economic conditions affect the economy in different ways, the price earnings ratio will fluctuate, reflecting anticipated market direction. If we can create a measuring tool to determine whether the price earnings ratio is suggesting an overvalued or undervalued market, investors will have a better idea about whether they should get into, or out of the investment market. This is the measuring tool we are trying to create with FVPER.

Allow me to introduce you to five stocks that we can use to test a case for the use of FVPER. These stocks are not high fliers from the Dot.com area, but they are household names with which we are all familiar.

There will be three moments in time selected to test FVPER. They are: August of 2000, October of 2002, and today.

The stocks:
Coca Cola
Dell Computer
General Electric
Microsoft
Wal-Mart

In August of 2000 everyone was piling into the market, books were suggesting the possibility of a Dow 36,000, and the phrase “New Paradigm” was on everyones lips. Between August of 2000 and today, the five companies mentioned above increased their earnings per share by 89.6%. Coca Cola lead the way with a 129% increase, while Microsoft had a 45% increase in their earnings. Like most investors who select such stocks and enjoy substantial earnings growth, you would expect an increase in the value of your holdings. Unfortunately, if you purchased one share of each of these fine companies in August 2000 and watched their combined earnings grow at a rate of almost 18% a year, you would have been rewarded by losing 14.8% of the value of your mini portfolio.

Why did these stocks fall while they “doubled” their earnings over a five year period? Was it a problem with sales, margins, poor management? The answer is no. I believe the reason investors lost money in these stocks is that they did not have the tools to determine whether the overall market was properly valued for investment entry. Without being able to determine the extent that the market was badly overvalued, investors lost money with even the best of equity investment. It is this market evaluation question for which FVPER may provide needed insight.

Let’s focus on the General Electric and consider its value using the FVPER evaluation. In August of 2000 General Electric was selling at $62.73 a share. The company was making $1.27 a share, and the price earnings ratio was 49.4. As a result, investors were willing to pay $49.40 for each one dollar of corporate earnings. [FVPER = one divided by the current prime rate]

In August of 2000 the prime interest rate was 9.5%. By dividing 9.5% into one, the calculation suggests that the relationship between interest rates and earnings may only support a price earnings ratio of 10.5. If one multiplies 10.5 by GE’s then current corporate earnings of $1.27 a share, it suggests that the price of the stock should have only been $13.33. Instead it was trading at $62.73 a share. General Electric stock, based on this historical relationship between the prime interest rate and the price earnings ratio of stocks in general, was “overvalued” by 370%. This seems to be an extraordinary number, yet if you do the same calculation on the remaining four stocks you find the stocks were “overvalued” by anywhere from 284% for Wal-Mart to 486% for Coca Cola. Based on historical evaluations, one certainly did need a “new paradigm” to justify these evaluations.

Now it’s October of 2002 and the Dow Jones Industrial Average has fallen to 7,533 from its August 2000 level of 11,215. General Electric has fallen from $62.73 to $24.60. The stock, falling by 61%, or $38 a share,, eliminates approximately 77% of the previously suggested excess evaluation. But there is a major positive factor to now consider. In an attempt to stimulate the slow August 2000 economy, the prime interest rate fell to 4.25%. FVPER now divides 4.25% into 1, suggesting that the combination of interest rates and earnings may now support a price earnings ratio of 23.5. While General Electric has fallen to $24.60, its earnings have increased from $1.27 a share in 2000 to $1.41 a share in 2002. At $1.41 a share, and considering the newly established FVPER of 23.5, the fair value of General Electric is $33.13 a share. FVPER suggests that General Electric is now under valued by approximately 34%!

Let’s stop here for a moment. I am suggesting that FVPER be used to determine whether you want to enter, or exit an investment market. If you had considered the FVPER evaluation in August of 2000, I do not believe you would have invested funds in the market. While others were scurrying into the market and touting a Dow of 36,000, you might have kept your cash on the sidelines. In sharp contrast, by October of 2000 FVPER told you that General Electric was 34% undervalued based on a combination of interest rate conditions and corporate earnings. You would have “pulled” your investment trigger!

Today the Dow Jones Industrial Average has rallied by 43% from that day in October of 2002, and General Electric’s stock has run alongside with an increase in value of 42.2%. While corporate earnings at GE have increased to $1.71 from the $1.41 of 2002, interest rates have unfortunately increased dramatically, as well. The prime interest rate today is 7.25%. This results in a FVPER evaluation of 13.7, instead of the 23.5 in October of 2002. The increase in corporate earnings at General Electric has not been able to outpace the increase in interest rates. As a result, General Electric is once again overvalued. (Based on FVPER calculations we “estimate” that General Electric is approximately 26% overvalued). Nevertheless, FVPER is only designed to give you an approximate fair market ratio for the overall market, not for individual companies.  General Electric is an outstanding company with exceptional growth and management. Although it is possibly overvalued using this ratio, is probably in actuality fairly valued.

[FVPER = Market evaluation, not stock evaluation].

Before we leave these five stocks, I report to you today that General Electric is the most fairly valued of the five, based on FVPER. Microsoft, because of only a modest improvement in corporate earnings since the year 2000, is the most overpriced stock at 187% fair value, using this ratio. (Nevertheless, wouldn’t you prefer to enter these stocks at this level of evaluation compared to the evaluations of August of 2000?)

This ratio will, of course, appear to be an over simplification of the many currents that run through the markets. Nevertheless, if one uses the ratio simply as an indicator of when to enter, or to shy away from market investment, I believe it becomes a valuable tool.

II. 2006 — Some thoughts — So, where do we go from here? Using FVPER, the relationship between corporate earnings and current interest rates suggests that the market should have a price earnings ratio of about 14. To put this number into perspective, using the capital weighted indexes of both the Dow and the S&P 500 we find that the price earnings ratios of these two indexes are 19.11% for the Dow and 19.86% for the S&P 500. (35% overvalued?)

These two capital weighted indexes suggest that the markets are over valued. On a much more positive note, in viewing Barron’s 50 stock average, which is a 50 stock index–not capital weighted, and giving each stock equal weight, one determines that the average price earnings ratio of these 50 stocks is currently 15. (7% overvalued)

I'd like to make two quick observations here. First, I believe FVPER suggests that the overall market is close to being properly priced at this moment. Second, comparing this 15 PE to the 20.5 PE, which is where the Barron’s 50 index stood last year, I believe that the market has correctly observed the increase in corporate earnings while at the same time discounted the price earnings ratio due to the increase in interest rates. (I believe the difference in the price earnings ratios of the capital weighted indexes versus the broader market is due to the speculative play that occurs when short term investors invest in index mutual funds and exchange traded funds These funds require substantial investment in so few individual stocks in these capital weighted indexes).

The economy continues to grow at a rate of over 3%, which is positive. I believe the Federal Reserve is close to ending what has appeared to be a never ending string of increases to its discount rate. As a result, if the interest rate increases subside and corporate earnings continue to increase at the present level, both the economy and the market may continue to improve.

At year-end, Business Week provided an interesting forecast including interviews with over 70 well-respected economists. In reviewing the economist’s predictions for the year-end (2006) performance for the Dow Jones Industrial Average, it would appear that 17% interviewed expected the market to increase in value by more than 11%. Forty-five percent expected a 6%-10% increase in value, 30% expected a 1%-5% increase and 8% of those interviewed expected the market to decline in 2006. Interestingly enough, it would appear that the economists forecast fairly equal growth in the Dow, S&P, and NASDAQ that might suggest that growth and value may provide equal performance in the coming year.

On the other side of those positive predictions are a substantial number of investors who may feel that, if interest rates continue to increase and the economy slows, the market will decline. Twenty-four percent of all S&P spiders, the exchange traded fund (ETF) that represent the S&P 500, are sold short at this time. Approximately 19% of Diamonds, the ETF for the Dow are sold short and QQQQ, which is the ETF representing the NASDAQ, has 35.5% of its outstanding shares sold short. Investors sell short in anticipation of the market falling, thus allowing the investor to cover their short positions for a cheaper price at a future date.

(This bit of information is a double edged sword because, if the economy continues to improve and interest rates stabilize, “short” investors will have to cover their short positions. This means that they will actually have to enter the market and buy those ETFs or risk potential loss. Such an action would certainly stimulate the market and push each of these indexes forward).

My concerns, which I voiced in substantial detail in our third quarter letter regarding the strength of the consumer, have dissipated a bit due to the wonderful decrease in gas prices. Prices have fallen in this area by as much as .95 cents a gallon, or about 32%. This has allowed the consumer to have renewed confidence, which has converted into what has appears to have been a solid Christmas retail season. Nevertheless, the accelerated debt payment requirements by credit card companies, along with the 81% increase in interest costs on home equity lines, may begin to take it’s toll on the consumer in the coming year. I believe consumers will attempt to pay down these increasingly expensive lines, which may retard consumer spending. The increase in mortgage rates and the leveling off of home values will eliminate the ability, or the desire, to refinance for the purpose of consumption. If the Fed discontinues its rate increases perhaps a soft landing is possible.

We will continue the balanced approach that has served us well in the last two years. We will continue to increase our international exposure, as I believe that the dollars’ strengthening has run its course. We will continue to lighten our real estate investment trust exposure which began in early 2005. You will note an increase in technology exposed funds along with a continued holding of our energy related securities.

The bottom line of concern for 2006, is interest rates, interest rates and interest rates. A leveling off, or even a decline in rates, will allow for continued growth and richer stock evaluations. A continued increase in interest rates will weigh heavily on the consumer and stock evaluations. We will be watching interest rates closely!

2005 market observations:

	12/31/04	3/18	6/26	10/31	12/31/05	Quarter Change	YTD Change
Dow	10,783	10,485	10,297	10,568	10,717	+1.4	(.6)
NASDAQ	2,175	1,992	2,053	2,151	2,205	+2.5	+1.3
S&P	1,211	1,174	1,191	1,228	1,248	+1.6	+3
Russell Value	656	647	660	681	685	+.5	+4.4
Russell Growth	493	471	480	500	513	+2.6	+4
Treasury	88.5	87.7	96.39	92.2	92	(0.1)	+3.9
Real Estate Index	123.4	111.3	125.6	128.3	129	+.05	+4.5

1. The fourth quarter provided positive results for both the Dow and NASDAQ, but even with this last quarter boost results for the year were relatively unchanged. The Dow lost 6/10 of 1% while the NASDAQ added 1.3% for the year.
2. Broader indexes faired a bit better with the S&P 500 increasing by 3% for the year and the Russell Value and Growth indexes providing 4.4% and 4% respectively for 2005.
3. Bond and real estate investment indexes provided 3.9 and 4.5% returns for investors in what may be the end of a spectacular three year run for both of these indexes.

IV. Odds and Ends –

• Early in 2005 we completed our move to the pure fee side of Fidelity, and although with any move there are a few bumps in the road, we are delighted with the service we are able to provide with this direct link to Fidelity. In the first quarter Fidelity will begin sending letters to our clients that will allow you to confirm that checks may be drawn on your account and sent to you at your address of record without signing a form for each request. We now have this service available to you but the SEC has required that a signed form be on file with Fidelity to continue to offer such a service. To not sign the form will result in you being required to sign a form each time you request a check from our office. (Automatic monthly distributions are unaffected). By signing the Fidelity form you are confirming that you would like to keep the ability to have money sent to you from your account without signing a form for each withdrawal.
• Attached with our letter is a copy of our privacy policy here at Clark Financial Advisors. This is provided to you as an SEC requirement. It may summed up as, “We don’t tell nobody about your business!”
• On a closing note we have decided that each quarter our office will make a donation in honor of our clients to Heifer international. Heifer International has worked to bring help, healing, and hope to millions of impoverished families worldwide since 1944. Each quarter one of our team members will have the opportunity to direct the donation into specific items that Heifer International offers to impoverished families. In this first quarter our donation is being used to donate a gift of a llama, honey bees, and a share of a knitting basket. Amanda McCollum, who has selected these items, provides her reason for selecting these gifts below:

From Amanda McCollum:

First, llamas provide Heifer families with invaluable sources of transportation, income and wool for making blankets, ponchos, carpet and rope.

Second, when placed strategically, beehives can as much as double some fruit and vegetable fields, therefore boosting a whole village.

Finally, a share of a knitting basket will allow struggling families the ability to earn income through shearing and spinning, weaving and finally selling woolen goods at market.

For more information on the Heifer International visit their website at www.heifer.org.

We appreciate your support and look forward to seeing you in the coming year.

Warmest Regards,

M. Brooks Clark 

MBC/alm

*Please remember that Clark Financial Advisors’ office is now located at 4128 Crosshaven Drive in Cahaba Heights. Please visit our website for pictures of our new office, as well as photos and an introduction to our staff. Our phone numbers are the same, but our mailing address is now P.O. Box 43828, Birmingham, AL 35243. For directions to our office visit our website or give us a call.

PLEASE NOTE: All checks to be added to your accounts should be made payable to: Fidelity

*Clark Financial Advisors is registered with the Securities and Exchange Commission (SEC) as a registered investment advisor and annually files an ADV with the SEC, as required. The ADV II form provides background on the firm and its principals. If you would like to receive a copy of this form please contact Jennifer Gibbs via email at Jennifer@clarkfinancialadvisors.com to receive a copy. You may also return this page of the letter with a note signifying your request for a copy of the ADV II filing for Clark Financial Advisors.

M. Brooks Clark

MBC/lh

PLEASE NOTE: All checks to be added to your accounts should be made payable to: Fidelity

*Clark Financial Advisors is registered with the Securities and Exchange Commission (SEC) as a registered investment advisor and annually files an ADV with the SEC, as required. The ADV II form provides background on the firm and its principals. If you would like to receive a copy of this form please contact Jennifer Gibbs via email at Jennifer@clarkfinancialadvisors.com to receive a copy. You may also return this page of the letter with a note signifying your request for a copy of the ADV II filing for Clark Financial Advisors.